Don't be duped: To get more return on bonds, you must accept more risk

Q. I am a very conservative investor with most of my money in bonds. One of them matured and the rates I am seeing offered on new ones are very low. How can I get more interest?

— Chuck in Viera 

A. Chuck, you can increase your interest income but be careful. Never forget that to get more return, you must accept more risk. There are thousands of outfits that will try to convince you they have created a magical way for you to get more return without giving something up. Don’t be duped by such illusions. High interest is far more likely to be a red flag than a good opportunity.

That said, the basic trade-offs for bonds haven’t changed. Bonds are obligations to pay certain amounts at certain times. When you buy a bond, you become a lender. The issuer owes you interest and a maturity value. Because the terms of the bond are contractual, you can assess their risks more reliably than ascertaining the risk/reward tradeoffs in something like stocks or commodities making bonds attractive to conservative investors.

One way to get larger interest payments is to buy bonds that mature farther out in the future. In return for agreeing to be a lender for a longer period of time, longer maturity bonds usually offer higher yields than bonds maturing sooner but not always. As I write this, even the 30-year treasury is sporting a yield of less than 1.5%.

A significant risk of owning longer-term bonds is that the value of the bond will drop when interest rates rise. Even safe U.S. treasures have this interest rate risk. For instance, a 30-year U.S. treasury bond has an effective duration of about 25 years. This means if interest rates rose 1%, you would expect the value of the bond to drop about 25%.

Another common way to get more yield is to buy bonds from issuers with lower credit ratings. If you tried to buy a car but had a bad credit rating, the interest rate on your loan would be higher than what would be offered to someone with stellar credit. You have to keep that in mind when you look at bonds. You are the lender. If a bond offers higher interest, it is because there are some doubts about the issuer’s ability to pay on time. If they could borrow at lower rates, they surely would.

The prices of corporate bonds, for instance, can fluctuate greatly based upon perceptions of corporate health or fears of a recession. Earlier this year when stocks dropped, many people were surprised that their bonds also dropped in value. For instance, on March 23, the day stocks bottomed this year, JNK — an exchange-traded fund that tracks high yield bonds — was down over 22%, too. A similar thing happened during the 2008 financial crisis. That is not what conservative investors would have wanted to experience.

Investors who want more yield must be willing to take on more risk of loss. There are other risks in buying bonds but changes in interest rates or changes in credit quality are two of the more dangerous ones. These risks are a classic example of how markets provide trade-offs between risk and reward. So, when reaching for yield, don’t reach too far.

Dan Moisand, CFP®, has been featured as one of America’s top independent fee-only financial planners by at least 10 financial planning publications and practices at one of America’s most decorated independent firms. For more info, e-mail him at dan@moisandfitzgerald.com, visit moisandfitzgerald.com or call 321-253-5400, ext 101.